Apple: Wells Cuts to Hold on Margin, Growth, Subsidy Concerns

By Tiernan Ray

Wells Fargo‘s Maynard Um this morning cut his rating on shares of Apple (AAPL) from Outperform to Market Perform, while maintaining a $536 to $581 “valuation range,” writing that despite some “new developments” in 2014, such as a smart watch, he is concerned about margins, lack of sufficient growth, and about wireless operators gaining more of an upper hand in dealings with the company.

Reflecting on “what 2013 tells us about 2014,” Um writes,

2013 was a busy year for Apple behind the scenes – the hiring of Angela Ahrendts (former CEO of Burberry) to run retail, Paul Deneve (former CEO of Yves Saint Laurent) and Kevin Lynch (former CTO of Adobe) to run separate special projects, Jay Blahnik (key role in Nike’s Fuelband) likely to work on the iWatch, and the acquisitions of 15 companies for new or existing products. We believe this points to some new developments in 2014 with regard to retail (we think iBeacon – an indoor proximity/positioning system – will be a major part of this), the launch of an iWatch, a relaunch of an improved Maps app and, in 2015, the launch of a television (or improved Apple TV product).

Um writes that gross margin may come under pressure from the introduction of a new “form factor” for the iPhone this year, an “iPhone 6,” claiming such has been the case in past:

The strength in shares from FY2008 to its peak in FY2012, in our opinion, was related to the secular growth story of the iPhone. Between the gross margin mix benefit, market share gain opportunity, and strong growth, there was a lot to be positive about. However, we believe that in the iPhone 6 cycle, gross margins will come under pressure as products following an “s” cycles typically tend to be impacted (historically, by up to 225bps on average) likely due to the launch of new form factors, which have different components and thereby reducing scale and leverage benefits. With the secular story largely over, we fear that the stock may be more susceptible to the direction of gross margins (as is typical of most hardware-related companies).

Um also thinks there is limited room for the the company to grow given that it has already swallowed the market caps of other electronics firms:

Exhibit 3 highlights the market caps of consumer electronics companies. As demonstrated in the exhibit, we believe Apple’s market cap gains came from the shifting of dollars (and, hence, market cap) from competitors rather than an increase in overall consumer spend or market opportunity. With Apple having gained significant market cap from other consumer electronics companies and continued pressures on the consumer wallet, we see limited market opportunity absent material share gains or improvements in consumer spend.

Here’s Um’s chart of how the company’s market cap has swallowed that of other electronics firms (click for larger image):

And lastly, he thinks there may be some sort of mean reversion in the amount carriers will spend to subsidize phones, away from the $400 they’ve been spending on each iPhone, and back to something like half that level:

We estimate wireless operators have been offering generous subsidies of ~$400 per iPhone to reduce the end market price consumers have to pay to more affordable levels. We believe subsidies prior to this may have been around half this level, albeit for more commodity voice and text (or limited data) handsets. We believe these higher subsidies helped to increase smart phone penetration and, consequently, data subscriber increases/potential for the operators.

On the plus side, Um notes warranty claims cost rose “meaningfully” last quarter, and may decrease going forward. Also, the company’s “deferred margin on component sales” was “surprisingly flat” last quarter, which could mean upside in the March quarter: “We assume management is not embedding a large reversal (which would be a gross margin benefit), which makes the company’s “core” gross margin guidance better, in our opinion, and makes for a better outlook for the March quarter (because the implied gross margin improvement is less accounting related).”

He lists as other possible positives the debut of new products, including iPhone 6, and the potential for higher share-repurchase and dividend authorizations.

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There are 24 comments

JANUARY 2, 2014 11:20 A.M.

Bill wrote:

Does Barron's pay these Jokers for writing such trash? Leave it to Barron's to publish such rubbish to keep the brakes on Apple. Didn't Maynard Um get Fired from UBS for such off the wall predictions. Maynard's concerns listed are all complete Bull Shi_ What a con job by Wells Fargo once again. You can bet Goldman Sachs was behind this trash and Maynard got a nice little XMAS gift from them in return for this POS. Life in the fast lane.

JANUARY 2, 2014 11:21 A.M.

Ed wrote:

Tim Cook is unaware of this downgrade. He is shopping for new Cool Jeans with Ron Johnson in downtown Cupertino

JANUARY 2, 2014 11:26 A.M.

PedroG wrote:

Wells Fargo is DEAD WRONG! Apple will report over $60 billion is sales this quarter. What fools!

JANUARY 2, 2014 11:27 A.M.

LonnieL wrote:

Why does this Wells analyst downgrade a company such as Apple that is undervalued and generating tremendous revenues year after year while Twitter who has no shown revenues enjoys another big day up for its investors? These idiot analysts seem to know nothing!

JANUARY 2, 2014 11:29 A.M.

Sam wrote:

Can we please have the SEC investigate Wells Fargo's net short position (options or shares) as of the date of Um's publication. And then investigate Wells Fargo's net position when Um reverses his opinion in a few days.

JANUARY 2, 2014 11:29 A.M.

Batman wrote:

Ummmm, ... sounds like stock manipulation.

JANUARY 2, 2014 11:30 A.M.

Peter wrote:

Tim Cook meeting with John Chambers from Cisco today to see how Apple can join the Graveyard for DEAD Stocks. Chambers will show him the tricks to getting Apple classified as a DEAD Stock and expedite Apple into the Dead Group. The Graveyard is only for stocks that are finished and will go nowhere for 10 years. one important criteria is that the CEO for a Graveyard Stock gets Filthy rich from stock options and bonuses, while Shareholders get Screwed. Apple, the new Cisco! Cook the new Chambers. Welcome to the Graveyard Apple.

JANUARY 2, 2014 11:31 A.M.

Dan wrote:

If Verizon cuts subsidies you would pay $ 400 for a 5s. So T-Mobile would be that much cheaper. I have 3 iPhones and 2 regular phones with Verizon and pay $ 283 a month (20 gig data)

With T-Mobile you pay $ 110 for 5 smartphones with 1/2 gig and unlimited 3g. So if you paid $ 200 for each phone and financed 3 phones over 2 year you pay $160 a month. After 2 years you stop paying but Verizon you still pay the same. Granted I did not add in tax.

Metropcs is owned by T-Mobile. They have $ 100 for 4 smartphones no tax 500mb data and balance 3 g unlimited.
Verizon is not giving up subsidies. They will get clobbered

JANUARY 2, 2014 11:39 A.M.

Paul wrote:

Don't fret Apple Shareholders! Tim Cook has hired the Monkeys from Career Builder.Com to run Apple's IR and PR Departments. The Monkeys will be tasked to publish any form of Good news that they can find on Apple. The Monkeys were last seen in the Apple Board Room throwing bananas at the White Board and drawing pictures of Humans on the flip charts. Get ready for some great news soon!

JANUARY 2, 2014 11:42 A.M.

Carmensenseman wrote:

We estimate, we believe, in our opinion........margins shrinking on a product that does not exist....... Now put aside that all of the points are subjective, and unsubstantiated, over 10 media outlets use this as their lead story. Repeat the unsubstantiated....... So my issue is not with the analyst , but the sheep that repeat, without any thoughtful debate. Apple draws clicks..... But Apple stock is also traded on algorithms , that pick up on words like downgrade, which obviously, this analyst has not done......

JANUARY 2, 2014 11:43 A.M.

lkonig wrote:

This is great. Sell sell sell. Um is an idiot. Downgrade but the article argues for an upgrade!!!!!!!!!! If you sell you are an Um......

JANUARY 2, 2014 11:55 A.M.

DBK wrote:

same thing they have been saying for years, nothing new......

JANUARY 2, 2014 12:07 P.M.

Sal wrote:

Tim Cook continues his Useless Leadership skills into 2014. Down 8 on a downgrade and no news. Go get them Timmy!

JANUARY 2, 2014 12:11 P.M.

Jack wrote:

It would be one thing if Mr. Um had come up with reasonable fears for downgrading the stock. Let's say a strong competitive phone that was a big hit for the holidays or poor results from Apple over the holiday period or even the lack of any new meaningful phone vendors in Apple's pipeline. Yet, the only thing he can come up with is future margins of the Iphone 6? We know the subsidy argument is a joke. Every major carrier knows they need the world's most popular phone and are making money on these Apple customers due to their stickiness and monthly spend. How Um can gloss over Q4 sales/margins, China Mobile, NTT DeComo, year over year comps, high likelyhood of a new product launch, continued share repurchase, etc. are beyond me. What other current tech stock is being judged on the margins of a product 3-4 quarters away? Once again it's inside games played by the so called smart money to scare the retail investor out of a stock. Tiernan, please update your readers on this downgrade as the year progresses.

JANUARY 2, 2014 12:30 P.M.

Moxie wrote:

Puh-LEEZE. The timing alone of this downgrade makes it suspicious. Obviously manipulating for short interests, better entries, and/or options rape. When someone asks you to believe something, you always have to ask yourself who benefits from that belief. The only questions are...who will benefit if the price drops, and who was paid to promote a negative perception?

JANUARY 2, 2014 12:33 P.M.

Anonymous wrote:

um makes the same mistake as many other analysts on wall street. he cites some theoretical concerns related to the market caps of other tech players and a theory that margins will be lower (with no real bottoms-up proof). the basis of his argument is that all companies will revert to some theoretical average. apple is the only hardware company that owns a software operating system, and that is what makes it unique. the other hardware players beat each other up on features and price points (low margin). apple grows its own unique operating system that is very sticky. the overall market opportunity for technology products is vast and apple has many opportunities to grow (it has less than 20% market share of mobile devices in units). he completely ignores the transition from pcs to tablets and the growth of apple's itunes revenues.

JANUARY 2, 2014 12:46 P.M.

Dan wrote:

The Weekly Apple options expire tomorrow, so there wasn't much time to bash the stock and drive the price down. This downgrade was written to correct that problem. What good analyst would downgrade a Stock based on Supposed Margin Problems on a product that is unannounced and is at least six months away. What an idiot!

JANUARY 2, 2014 1:09 P.M.

orion wrote:

Um is a couple of weeks late with his downgrade, but better late than never. I was sounding a red alert about impending margin implosion and rapid demand erosion a couple of weeks ago when top-of-the-line Apple products were on fire sale at deep discounters like Walmart, Target, Best Buy, etc., and yet supplies were as plentiful as ever. The fire sale intensifies today in Japan (and throughout Asia) where customers are getting thousands worth of products through the so-called Lucky Bags for under $400. You don’t have to be a rocket scientist to know things are going downhill fast at Apple.

I also warned that Apple was going to report a negative yoy growth quarter later this month and a loudsy guidance in spite of the much hyped CM contract, which Apple had no choice but to sell their phones and tablets to CM at rock bottom prices to dump excess inventory. I predicted analysts would need to cut estimates to bring them closer to reality and to turn an earnings miss into a beat to prop up stock price, just like they did the last several quarters.

Expect the AAPL house of pain to become house of terror.

JANUARY 2, 2014 3:18 P.M.

Ron wrote:

Somebody go wake up Timmy Cook and tell him it's almost time to go home.

JANUARY 2, 2014 3:58 P.M.

donjean2 wrote:

The Wells Fargo write up is focused on the US market. They do not understand the potential of China Mobile because the largest market for Apple Products lies in the expansion of the middle class in China and the rest of Asia. They just do not understand the money flowing around China and the money flowing into California that is used to buy real estate in cash. They don't realize the flow on money because money from China does not rely on banks since they now have the means to connect to their accounts through Chinese banks established last year. This is a buy opportunity for those wanting to profit from this pullback.

JANUARY 2, 2014 4:06 P.M.

Ha! Subsidy? GM Shrinkage? wrote:

How many years have we been hearing this?

I do see BCE's Bell, the company with the worst customer service offering $200 to Rogers customers to switch. They're also dangling a special red Samsung smartphone. By the way. How come we're not seeing reports re all the Samsung Galaxy devices w battery issues? Hmm. Bell's shill Clara Hughes is even sporting a Samsung Gear watch. Too bad she can't tell time. She does help victims though by riding her bicycle around and around them. Why? Well. It makes sense to her and her handlers and Bell's CEO. What next? Clara's Big Rules?!

Blah blah blah...

JANUARY 2, 2014 7:20 P.M.

Paul wrote:

Angela will be taking the reins as Apple CEO. It will be announced on the earnings call this month.

JANUARY 2, 2014 7:51 P.M.

Ed wrote:

Did Apple and China Mobile reach an agreement? Lol

JANUARY 2, 2014 8:17 P.M.

Anonymous wrote:

How much did Um receive to write this BS story? I'm thinking $50K. Nice days work Maynard.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.